The Impossible Trinity Monetary Autonomy

Fixed/Pegged Exchange Rate

International Free Flow of Capital

The Impossible Trinity: in Context of Sri Lanka

Sri

Lanka has a current account deficit in the balance of payments. (Imports double

of exports)
The

central bank is holding interest rates(independent monetary policy) and a

pegged exchange rate.

To

keep this policy in check the Central Bank has been a net buyer of US dollars in

the FOREX market as post war inflows of aid, investment and greater export revenue strengthened the Rupee.
By

intervening there is a resultant liquidity in the market that may fuel inflationary

pressures.

If

the resultant liquidity is sterilized(bought as foreign reserves by the CB) it

increase the pressure on interest rates to rise causing further inflow of capital.


To break the cycle of sterilized intervention the dollar peg has be made 'flexible' or

the rupee floated.



Or the Interest rates have to rise followed by a depreciation of the currency with the

exchange rate pegged with foreign reserves. There is no independence of monetary policy in this case.

you can either achieve International flow of capital with a pegged exchanged rate with no autonomy of monetary policy or you can achieve flow of capital with autonomy of monetary policy with a flexible exchange rate. All three cannot be achieved at once. The impossible trinity cannot be achieved.
Hence